my2cents4u

The Tale of Two Growth Stories: General Electric and China

Uwe Bott

October 24, 2014 

 

Jack Welch reigned over General Electric for 20 years between 1981 and 2001. During that time, market capitalization of GE stock rose from $13 billion to more than $550 billion, sales quadrupled and profits grew six-fold.

Double-digit annual growth was achieved in good as well as in bad economic times. Consequently, GE stock vastly outperformed the S&P 500, creating outstanding shareholder value.

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In fact over the years, Jack had convinced himself and investors that this was an entirely predictable and sustainable growth pattern for the company. Much of his legacy was based on that. What possibly Jack, but certainly investors were missing was that some divisions of GE could only keep up with their numbers after the mid-1990s by selling their most valuable assets. In a sense, that was the opposite of a fire sale.  These assets provided very generous returns to divisions that were struggling to grow organically.

Implicitly, however, this also demonstrated some inherent limits to a business model that assumed double-digit growth ad infinitum.  Not surprisingly things began to change in 2001, albeit with bad timing for the then-incoming new CEO of GE, Jeff Immelt.

GE's stock prices had peaked at around $53 in 2000, but would never again reach such heights. And in fact, while GE stock had outperformed the S&P 500 during Jack Welch's years as CEO, it has largely performed less well than that index under Immelt as the graph below illustrates.

To be sure, this was not Immelt's fault. A number of factors played a very important role. First, the economy was in the midst of a recession, when Immelt took over.  Moreover, Immelt had the bad

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fortune to take the helm of GE just 4 days before the tragic events of 9/11. Among the entire trauma, these events also caused further harm to the U.S. economy. But the events also led to $600 million in losses for GE's insurance business and made a serious medium-term dent in the prospects of GE's aircraft business. Of course, the Great Recession was a further blow to the company.

And yet, this still does not explain why GE did so much worse than the S&P 500 between 2002 and today and why the company's profits rose by only 12% between 2002 and 2013. That double-digit growth occurred over the entirety of Immelt's leadership, not annually as under Jack Welch.

The main reason, for what shareholders might consider as underwhelming, is that the tremendous growth of GE during Jack Welch's years created a company with such a humongous asset base that it simply outgrew a business model that could reasonably assure investors that profits would rise at least 10% a year. GE has critical mass in the corporate world. Such critical mass does not allow for sustainable double-digit growth any longer.

In that sense, it is not too dissimilar from the world's largest economy, the United States. At a GDP of $17 trillion it is simply implausible, and in fact it would be highly destabilizing, if the U.S. economy grew at 10% per year. In year one, such growth would catapult GDP from $17 trillion to $18.7 trillion. As such growth rates would compound over years, it is beyond global absorptive capacity to sustain such pace.

And this is exactly, where there are parallels to China's current growth conundrum. Just two years before Jack Welch took over GE, then-de facto leader of China, Deng Xiaoping, began opening up the Chinese economy in 1979.

The results were astonishing. During the 30 years between 1982 and 2011, the Chinese economy indeed grew by exactly 10% per annum. In 2014, China's GDP will be 35 times larger than it was in 1982. In fact, China now has the second-largest economy in the world at a projected $10.4 trillion.  As much of China's growth was export-driven, its international reserves grew by leaps and bound from a measly $7 billion in 1982 to a project $4.2 trillion in 2014.

China's economy now has critical mass. For decades, it was the mantra of Chinese leadership that economic growth below 8% was unacceptable and even socially unsustainable.  This is no longer so. In 2012 and 2013, GDP grew by "only" 7.7% each and growth in 2014 is expected to be even slower.  

The reason is simple. Much like in the case of GE, China's "asset base", its GDP, has grown so large that double-digit growth is no longer sustainable.  In the case of GE, the first warning signals were that some divisions had to sell valuable assets to make their numbers. In the case of China, the signals are that the current supply of low-cost consumer products provided by China exceeds demand in the more advanced countries. This is partly so because China's supply has multiplied, flooding global markets. Partly it is the result of demographic changes and a prolonged economic crisis in the more advanced countries, which has dampened demand.

Of course, all of this has led to advice from outside of China that it change its business model from one driven by investments to one driven by consumption. After all, China has a very large population and, in terms of per capita income, it is still a fairly poor country. And yet, gross domestic savings stand at over 50% of GDP. So, there is a lot of growth potential in the domestic Chinese economy.

Still, a shift from the export-driven to a consumption-driven growth model is easier said than done because as a society China is not as open as its economy. Moreover, China itself is facing one of the greatest demographic challenges of humankind.  By 2050, one-fourth of all Chinese will be older than 65. In fact, as has been said many times before, China will be old before it will be rich.

Moreover and in spite of high domestic savings, there are major economic imbalances in China. In order to maintain high growth rates during this difficult transition period, credit growth has been out of control for years. Between 2009 and 2013 domestic credit has grown at an annual average of 19.7%. It does not take an economist to figure that returns were probably negative for a lot of that lending, since GDP only grew at an annual rate of 8.9% during that time period.

China's banking system is now two-and-a-half times the size of its GDP and it is twice as large as the U.S. system. Meanwhile, the balance sheets of financial institutions are badly impaired; although it is everybody's guess how badly. State-owned corporations as well as the country's provinces and municipalities are deeply indebted. The seriousness of this problem is illustrated by the fact that a Chinese audit in late 2013 determined that local governments alone had some $3 trillion in debt. In looking at these challenges, China's enormous international reserves are quickly put in perspective.

Size matters. And China is now an economy that needs a comprehensive makeover and one that requires transparency. This is easy undertaking. China's medium-term growth potential may not be much greater than 5% per annum. However, reaching that potential requires dealing with existing imbalances and managing social implications of such relative decline. One thing is for certain, China's "stock" much like GE's will fall and it will find a new equilibrium.Enter content here

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